R&D Capitalization Under GAAP: Practical Guide to Compliance, Tracking, and Risks

R&D Expense vs. Capitalization: The Core Principle

For US-based SaaS, Biotech, and Deeptech startups, research and development isn't just a line item; it's the engine of future value. Seeing massive R&D payroll hit the profit and loss statement each month, however, can be unnerving. It shrinks reported profitability and can complicate fundraising conversations with investors focused on metrics like EBITDA.

The solution lies in understanding how to capitalize R&D costs under US GAAP, a process often clouded by confusing rules. This guide provides a practical framework for founders to identify what qualifies, set up a simple tracking system, and understand the impact on their financials, ensuring US GAAP compliance for startups without derailing growth. You can find more resources in the R&D Project Accounting & Capitalisation hub.

At its simplest, expensing a cost means it immediately reduces your profit on the Profit & Loss (P&L) statement. Capitalizing a cost, however, converts it into an asset on your Balance Sheet. This asset is then gradually expensed over its useful life through a process called amortization. For R&D, the default rule under US GAAP is clear.

Under US GAAP (ASC 730), most R&D costs must be expensed as they are incurred.

This conservative principle is the baseline for all industries. However, a critical exception exists that primarily benefits software companies, creating a path to capitalization for certain development activities.

An exception exists for software development costs incurred after 'technological feasibility' has been established. (ASC 730)

Once capitalized, these costs do not remain on the balance sheet indefinitely. They are amortized, meaning they are expensed systematically over their estimated useful life. Industry benchmarks show that capitalized software development costs are typically amortized over 3-5 years.

How to Capitalize R&D Costs: Identifying Qualifying Activities Under ASC 730

This is where most founders get stuck. Your engineering team is engaged in a wide range of activities: planning, designing, coding, and testing. Deciphering which of these can be capitalized versus expensed hinges on understanding one key milestone: ‘technological feasibility.’

Technological feasibility is the point in the development cycle where you have proven that your product can be built. It’s not just an idea; it's a confirmed technical plan. In practice, this is often the point when you have completed a detailed program design or a working model that resolves the significant technical risks of the project.

The timeline of activities is critical for determining the correct accounting treatment. Costs incurred before this milestone are considered too uncertain to be an asset and must be expensed. Costs incurred after the product is ready for customers are considered operational and must also be expensed.

Costs incurred before establishing technological feasibility (planning, design, research) must be expensed. (ASC 730)

Costs incurred after product launch (maintenance, bug fixes, minor upgrades) must be expensed. (ASC 730)

To make this clear, here is a breakdown of a typical software development lifecycle:

Phase 1: Before Technological Feasibility (Expense These Costs)

This phase includes all preliminary and exploratory work. These costs are expensed as they are incurred.

• Conceptual formulation and high-level design
• Research, discovery, and requirements gathering
• Evaluating alternative technological approaches
• High-level system architecture and planning

MILESTONE: Technological Feasibility is Established
(You have a detailed program design or a functional working model that proves the core technology.)

Phase 2: After Feasibility, Before Launch (Capitalize These Costs)

This is the core development phase where the actual software asset is created. Eligible costs in this phase are capitalized.

• Writing and testing code for new features and modules
• Building and developing the product based on the detailed design
• Activities directly related to preparing the software for its intended use

MILESTONE: Product is Released to Customers
(The software is available for general release.)

Phase 3: After Launch (Expense These Costs)

Once the product is live, costs shift to ongoing support and maintenance. These are expensed.

• Maintenance and bug fixes
• Customer support and end-user training
• Minor, routine updates and enhancements that do not add substantial new functionality

Application for SaaS, Biotech, and Deeptech

For SaaS companies, this model is straightforward. Building a new AI-driven analytics module is a capitalizable project during Phase 2. In contrast, fixing a bug in the user login flow is a Phase 3 maintenance activity and must be expensed.

For Biotech and Deeptech startups, however, the rules are far stricter. The exception for technological feasibility is specific to internal-use and external-use software development. The vast majority of non-software R&D, such as laboratory research, compound screening, clinical trials, or hardware prototyping, does not qualify for capitalization under ASC 730. This accounting treatment is why pre-revenue life sciences companies often report significant net losses, as their primary value-creating activities must be expensed immediately.

A Pragmatic System for Tracking Capitalizable R&D Costs

Implementing a tracking system does not require expensive software or turning your engineers into accountants. For a startup using accounting software like QuickBooks, an auditor expects a logical, documented, and consistently applied process. A simple spreadsheet is often perfectly adequate.

Here is a four-step process to build a reliable tracking system:

1. Define Your Projects Clearly. Separate work into distinct projects or buckets. For example, you might create 'New Feature: AI Reporting Dashboard' (a capitalizable project) and 'General Maintenance & Support' (an expense bucket). Be specific in an internal memo about what each project entails and why it qualifies for capitalization.
2. Gather Time Allocations from Your Team. At the end of each month, ask your engineers or project leads to provide a good-faith estimate of how their time was split across these defined projects. An engineer might report 70% on the Reporting Dashboard, 10% on a new API integration, and 20% on maintenance. The goal is reasonable accuracy, not perfect, minute-by-minute time tracking.
3. Use a Simple Allocation Spreadsheet. Create a spreadsheet to calculate the capitalizable portion of your R&D payroll each month. For most early-stage startups, a simple, consistently applied spreadsheet is all an auditor expects to see. Your template can have columns like these:
   • Engineer Name
   • Total Monthly Salary & Benefits
   • % on Capitalizable Project A
   • % on Capitalizable Project B
   • % on Maintenance/Expense
   • Capitalizable Amount (Calculated: Total Compensation * Sum of % on Capitalizable Projects)
   • Expense Amount (Calculated: Total Compensation * % on Maintenance/Expense)
4. Make the Journal Entry in Your Accounting System. Once you have the total Capitalizable Amount for the month, you post a journal entry to move the cost from an expense to an asset. If your R&D team's total payroll was $50,000 and you calculated that $30,000 was for capitalizable activities, the entry in QuickBooks is:
   • Debit (increase) an asset account: Create a new asset account on your Balance Sheet called 'Capitalized Software' and debit it for $30,000.
   • Credit (decrease) an expense account: Reduce your 'R&D Payroll Expense' account on your P&L by $30,000.
   This entry correctly reflects that $20,000 remains as an R&D expense for the month, while $30,000 has become a balance sheet asset to be amortized later. The same logic applies to contractor invoices; code each invoice or line item to the appropriate asset or expense account based on the work performed.

The Strategic Impact of Your R&D Capitalization Policy

So, what really happens if you get this wrong or ignore it? The consequences primarily surface during critical business moments like audits, fundraising, or seeking debt financing, and they directly affect how your company’s financial health is perceived.

On Your Financials

The most immediate impact of capitalization is on your reported profitability. By moving a large portion of developer salaries from an expense to an asset, your net income and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) will look healthier. For example, capitalizing $300,000 in a year that would have been an expense directly increases your annual EBITDA by $300,000. While this can be tempting, it is a double-edged sword. An overly aggressive capitalization policy is a major red flag for savvy investors and auditors.

During Fundraising

Potential investors and their due diligence teams will absolutely request and analyze your R&D capitalization policy. A clean, defensible, and consistently applied policy signals financial maturity. If your policy is inconsistent, poorly documented, or appears designed to artificially inflate EBITDA, it can erode trust. This can lead to requests for financial restatements or cause investors to "normalize" your financials by treating all R&D as an expense, potentially delaying or jeopardizing the entire deal.

In an Audit

When you undergo a financial audit, your capitalization process will be tested. Auditors will ask to see your written policy, tracking spreadsheets, project plans, and journal entries. They perform substantive testing, selecting samples of capitalized costs and tracing them back to the source documentation to verify they meet the criteria under ASC 730. Having this system prepared saves significant time, cost, and friction during the audit process.

For R&D Tax Credits

Finally, it's important to note that the rules for R&D tax credit eligibility are different from US GAAP capitalization rules. The tracking system you build for financial reporting is an excellent foundation for identifying qualified research expenses for the tax credit, but it requires a separate analysis based on IRS rules. For guidance on tax treatment, see information on amortizing R&E expenditures under TCJA and refer to the IRS instructions for Form 3115 for any changes in tax accounting methods.

Key Principles for a Defensible R&D Capitalization Policy

The principles of R&D capitalization can feel theoretical, but their application should be pragmatic. For an early-stage founder, the goal is to build a simple, defensible system that stands up to scrutiny without creating an administrative burden.

• When in Doubt, Expense It. This is the most conservative and safest approach under US GAAP. If an activity falls into a gray area, treating it as an expense is rarely the wrong answer from a compliance perspective.
• Software Is the Main Exception. Remember that the opportunity to capitalize R&D costs under ASC 730 is almost exclusively for software development. For US-based biotech and deeptech companies, the default is to expense nearly all R&D as it is incurred.
• Start Simple and Be Consistent. You do not need complex software. A monthly spreadsheet tracking time allocations against defined projects is sufficient for most startups through a Series A. Consistency in your method is far more important to an auditor than its complexity.
• Document Your Policy. Create a simple, one-page internal memo outlining your approach. Define what 'technological feasibility' means for your product development cycle and list the types of activities you capitalize versus expense. This document is your first line of defense in an audit.
• Consult Your Accountant. Use this guide to structure your process, but always review your final policy and journal entries with your fractional CFO or accountant. They can ensure it is implemented correctly within your chart of accounts and aligns with your overall financial strategy. For more details, visit our R&D Project Accounting & Capitalisation hub.

Frequently Asked Questions

Q: What about salaries for product managers or QA testers?

A: Generally, time spent by product managers on defining requirements before technological feasibility is expensed. Time spent after feasibility on detailed feature design for developers can often be capitalized. Quality assurance testing directly related to bringing new, capitalizable software to market is also typically eligible for capitalization.

Q: What happens if we abandon a project after capitalizing costs?

A: If a capitalized software project is abandoned, all previously capitalized costs associated with it must be written off immediately. This means they are recognized as an expense on the P&L in the period the decision is made, which can cause a significant one-time hit to profitability and should be documented carefully.

Q: How does capitalization affect company valuation?

A: While capitalization boosts short-term EBITDA, sophisticated investors often adjust for it when valuing a company, especially when using revenue or EBITDA multiples. They focus on cash flow and quality of earnings. A reasonable, consistent policy signals maturity, but an aggressive one can be a red flag that hurts trust and valuation.

Q: Can we start capitalizing R&D costs later if we've been expensing everything?

A: Yes, you can adopt a capitalization policy if you determine you have eligible costs. However, this is considered a change in accounting principle. You must apply the new policy consistently going forward and be prepared to justify the change to your auditors. It is best to establish a policy as soon as you begin development.